Global recessionary forces gather

The global economy this year will exhibit some similarities with conditions that prevailed in 2012. No surprise there. We face another year where global growth will average about 3 per cent, but with a multi-speed recovery: in the developed world, a sub-par, below-trend annual rate of 1 per cent; in emerging markets close-to-trend rates of 5 per cent. But there are other important differences.

Painful deleveraging – less spending and more saving to reduce debt and leverage – is continuing in most advanced economies, which implies slow economic growth. But fiscal austerity will envelop most advanced economies this year, rather than just the euro zone periphery and Britain. Indeed, austerity is spreading to the core of the euro zone, the US and other advanced economies (with the exception of Japan). Given synchronised fiscal retrenchment in most advanced economies, another year of mediocre growth could give way to outright contraction in some countries.

With anaemic growth in most advanced economies, the rally in risky assets that began in the second half of 2012 has not been driven by improved fundamentals, but by fresh rounds of unconventional monetary policy. Most major advanced economies’ central banks – the European Central Bank, the US Federal Reserve, the Bank of England and the Swiss National Bank – have engaged in some form of quantitative easing, and are now likely to be joined by the Bank of Japan, which is being pushed toward more unconventional policies by Prime Minister
Shinzo Abe
’s new government.

Moreover, several risks lie ahead. First, America’s mini-deal on taxes has not steered it fully away from the fiscal cliff. Sooner or later, another ugly fight will take place on the debt ceiling, the delayed sequester of spending and a congressional “continuing spending resolution" (an agreement to allow the government to continue functioning in the absence of an appropriations law). Markets may become spooked by another fiscal cliffhanger. And even the current mini-deal implies a significant amount of drag – about 1.4 per cent of gross domestic product – on an economy that has grown at barely a 2 per cent rate over the past few quarters.

Second, while the ECB’s actions have reduced tail risks in the euro zone – a Greek exit and/or loss of market access for Italy and Spain – the monetary union’s fundamental problems have not been resolved. Together with political uncertainty, they will re-emerge with full force in the second half of the year.

After all, stagnation and outright recession – exacerbated by front-loaded fiscal austerity, a strong euro, and an ongoing credit crunch – remain Europe’s norm. As a result, large – and potentially unsustainable – stocks of private and public debt remain. Moreover, given aging populations and low productivity growth, potential output is likely to be eroded in the absence of more aggressive structural reforms to boost competitiveness, leaving the private sector no reason to finance chronic current-account deficits.

Third, China relied on another round of monetary, fiscal and credit stimulus to prop up an unbalanced, unsustainable growth model based on excessive exports and fixed investment, high saving and low consumption. By the second half of the year, the investment bust in real estate, infrastructure and industrial capacity will accelerate. And, because the country’s new leadership – which is conservative, gradualist and consensus-driven – is unlikely to speedily implement reforms to increase household income and reduce precautionary saving, consumption as a share of gross domestic product will not rise fast enough to compensate. The risk of a hard landing will rise by the year’s end.

Fourth, many emerging markets – including Brazil, Russia, India, and China – are experiencing decelerating growth. Their “state capitalism" – a large role for state-owned companies, an even larger role for state-owned banks, resource nationalism, import-substitution industrialisation, and financial protectionism and controls on foreign direct investment – is the heart of the problem. Whether they will embrace reforms aimed at boosting the private sector’s role remains to be seen.

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Finally, serious geopolitical risks loom large. The entire greater Middle East is socially, economically and politically unstable. While an outright military conflict between Israel and the US on one side and Iran on the other side remains unlikely, it is clear negotiations and sanctions will not induce Iran’s leaders to abandon efforts to develop nuclear weapons. With Israel refusing to accept a nuclear-armed Iran, and its patience wearing thin, the drums of actual war will beat harder. The fear premium in oil markets may significantly rise and increase oil prices by 20 per cent, leading to negative growth effects in the US, Europe, Japan, China, India and all other advanced economies and emerging markets that are net oil importers.

While the chance of a perfect storm – with all of these risks materialising in their most virulent form – is low, any one of them alone would be enough to stall the global economy and tip it into recession. And while they may not all emerge in the most extreme way, each is or will be appearing in some form. As 2013 begins, the downside risks to the global economy are gathering force.